Least Cost Decisions
Least Cost Decisions:
Revenues are not directly involved in some decisions. For example, a company that does not charge for delivery service may need to replace an old delivery truck, or a company may be trying to decide whether to lease or to buy its fleet of executive cars.
In situations such as these, where no revenues are involved, the most desirable alternative will be the one that promises the least total cost from the present value perspective. Hence, these are known as least cost decisions. To illustrate a least cost decision, consider the following data:
Example:
ValTek Company is considering the replacement of an old threading machine. A new threading machine is available that could substantially reduce annual operating costs. Selected data relating to the old and the new machines are presented below:
Old Machine  New Machine  
Purchase cost when new  $200,000  $250,000 
Salvage value now  30,000  — 
Annual cash operating costs  150,000  90,000 
Overhaul needed immediately  40,000  — 
Salvage value in six years  0  50,000 
Remaining life  6 years  6 years 
ValTek Company uses a 10% discount rate 
Total Cost Approach or Total Cost Method:
Following is the analysis of the alternatives using total cost approach:
The Total Cost Approach (Lease Cost Decision)
Item  Year(s)  Amount of Cash Flows  10% Factor*  Present Value of Cash Flows 
Buy the new machine:  
Initial investment  Now  $(250,000)  1.000  $(250,000)** 
Salvage of the old machine  Now  30,000  1.000  30,000** 
Annual cash operating cost  1 – 6  (90,000)  4.355  (391,950) 
Salvage of the new machine  Now  50,000  0.564  28,200 


Net present value  583,750  


Keep the old machine:  
Overhaul needed now  Now  $(40,000)  1.000  (40,000) 
Annual cash operating costs  1 – 6  (150,000)  4.355  (653,250) 


present value of net cash outflows  $693,250  


Net present value in favor of buying the new machine  $109,500  


* All present value factors are from Future Value and Present Value Tables page – Table 3 and Table 4. ** These two figures could be netted into a single $220,000 incremental cost figure ($250,000 – $30,000 = $220,000) 
As shown in the above solution, the new machine has the lowest total cost when the present value of the net cash outflow is considered.
Incremental Cost Approach or Incremental Cost Method:
An analysis of the two alternatives using the incremental cost approach is presented below:
The Incremental Cost Approach (Lease Cost Decision)
Item  Year(s)  Amount of Cash Flows  10% Factor*  Present Value of Cash Flows 
Incremental investment to buy the new machine  Now  $(210,000)  1.000  $(210,000)** 
Salvage of the old machine  Now  30,000  1.000  (30,000)** 
Salvage in annual cash operating costs  1 – 6  60,000  4.355  261,300 
Difference in salvage value in six years  6  50,000  0.564  28,200 


Net present value in favor of buying the new machine  $109,500  


* All present value factors are from Future Value and Present Value Tables page – Table 3 and Table 4. ** These two items could be netted into a single $180,000 incremental cost figure ($210,000 – $30,000 = $180,000). 
This solution represents the differences between the alternatives as shown under the total cost approach.
In Business  Trading in that Old Car?Consumer reports magazine provides the following data concerning the alternatives of keeping a four year old Ford Taurus for three years or buying a similar new car to replace it. The illustration assumes the car would be purchased and used in suburban Chicago.
Consumer Reports is ordinarily extremely careful in its analysis, but it has omitted in this case one financial item that would clearly differ substantially between the alternatives and hence would be relevant. What is it? Source: “When to Give Up on Your Clunker,” Consumer Reports, August 2000, pp. 1216. 
You may also be interested in other articles from “capital budgeting decisions” chapter:
 Capital Budgeting – Definition and Explanation
 Typical Capital Budgeting Decisions
 Time Value of Money
 Screening and Preference Decisions
 Present Value and Future Value – Explanation of the Concept
 Net Present Value (NPV) Method in Capital Budgeting Decisions
 Internal Rate of Return (IRR) Method – Definition and Explanation
 Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
 Net Present Value (NPV) Method – Comparing the Competing Investment Projects
 Least Cost Decisions
 Capital Budgeting Decisions With Uncertain Cash Flows
 Ranking Investment Projects
 Payback Period Method for Capital Budgeting Decisions
 Simple rate of Return Method
 Inflation and Capital Budgeting Analysis
 Income Taxes in Capital Budgeting Decisions
 Review Problem 1: Basic Present Value Computations
 Review Problem 2: Comparison of Capital Budgeting Methods
 Future Value and Present Value Tables
Other Related Accounting Articles:
 Inflation and Capital Budgeting Analysis
 Capital Budgeting: The Net Present Value
 Incremental Cash Flow Analysis
 Joint Product Cost Analysis for Managerial Decisions and Profitability Analysis
 Pooled Internal Rate of Return
 Financial Leverage
 Turn Over Rate Calculation
 Bank Investment Contract
 Paid In Capital
 Installment Method of Revenue Recognition
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